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Financial Statement Analysisand Security Valuation
Stephen H. Penman
Financial Statement Analysisand Security Valuation
Stephen H. Penman
Prepared by
Peter D. Easton and Gregory A. SommersFisher College of Business
The Ohio State University
With contributions by
Stephen H. Penman – Columbia University
Luis Palencia – University of Navarra, IESE Business School
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Part II
The Analysis of
Financial Statements
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Chapter 7The business activities
- Financing
- Investing
- Operating
and the financial statements
Chapter 11The Analysis of Profitability
Layout of Part II
Chapter 8The Statement of Stockholders’ Equity
Chapter 9The Balance Sheet and Income Statement
Chapter 10The Statement of Cash Flows
Operating assets/liabilities
Financing assets/liabilities
Operating income/expense
Financing income/expenseChapter 12The Analysis of Growth and Sustainable Earnings
Part IIPage 208
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Business Activities andFinancial Statements
Chapter 7
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Chapter 7 Page 211What You Will Learn in This Chapter
• How businesses are organized to generate value for shareholders
• The difference between operating and financing aspects of a business
• How business activities are reported in financial statements
• How financial statements are organized to highlight value added
• How business activities articulate and how financial statements articulate
• The four cash flows of a business and how they relate to each other
• Why free cash flow does not affect value added
• How accrual accounting captures value added
• A set of accounting relations that summarize how business activities drive financial statements
• A template for how we will reformulate and articulate the financial statements
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Business Activities:All the Stocks & Flows
• Ch.1 - Firm has 3 activities– Financing– Operating– Investing
• Ch. 2 - Financial Statements record– Stocks– Flows
Product and Input Markets
Customers
Suppliers
The FirmCapital Markets
Debt Holders
or Issuers
Share
Holders
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d
The FirmCapital Markets
NetFinancial
Assets
(NFA)
Chapter 7 Page 212
Figure 7.1Cash Flows Between the Firm and Claimants in the Capital Market
• F is net cash flow to debt holders (or issuers)
• d is net dividend to shareholders
Share
Holders
Debt Holders
or Issuers
F
Financing Activities
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I
C
Business Activities:ALL THE CASH FLOWS
• C is net cash (flow) from operations
Operating Activities Financing Activities
• I is net cash invested in operating assets
• C-I is “free cash flow”
• If NFA are negative, they are Net Financial Obligations (NFO)
Chapter 7 Page 214
Figure 7.2
The FirmCapital Markets
Debt Holders
or Issuers
Share
Holders
NetFinancial
Assets
(NFA)
NetOperating
Assets
(NOA)
(NFO)
F
d
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A fundamental accounting identity:
• C = Net cash from operations• I = Net cash outflow for investing (purchases, divestments)• C - I = Free cash flow• d = Net dividends to shareholders (including common dividends, stock
issues...)• F = Net cash outflow for debt financing (principal + interest)
The treasurer’s rule:– If C - I - i > d : lend or buy down own debt– If C - I - i < d : borrow or reduce lending
i is net interest paid
CCEFdIC
Chapter 7 Pages 213-215The Cash Conservation Equation
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Financial Activities:Stocks & Flows
The cash flows flow into/out of the financial assets: their change must be explained by the four flows components of the equation.
For Financial Assets (FA)
For financial obligations (FO)
(it is interest paid)
For given interest payments and net dividends, cash flow from operations (C) reduces borrowing and cash investment (I) increases it
tttt1tt diICFAFA
tttt1tt diICFOFO
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Chapter 7Page 215
Reformulated Statementof Cash Flows
Cash flows from operations C
Cash investment in operations (I)
Free cash flow from operations C - I
Equity financing flows:
Dividends and share repurchases XX
Share issues (XX) d
Debt financing flows:
Net purchase of financial assets XX
Interest on financial assets (XX)
Net issue of debt (XX)
Interest on debt XX F
Total financing flows d + F
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I
C
Business Activities:ALL THE CASH FLOWS
• C is net cash (flow) from operations
• I is net cash invested in operating assets
• C-I is “free cash flow”
• If NFA are negative, they are Net Financial Obligations (NFO)
Chapter 7 Page 214
Figure 7.2
The FirmCapital Markets
Debt Holders
or Issuers
Share
Holders
NetFinancial
Assets
(NFA)
NetOperating
Assets
(NOA)
(NFO)
Operating Activities Financing Activities
F
d
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Chapter 7Page 216Balance Sheet
Assets
Operating assets OA
Financial assets FA
Total Assets OA + FA
Equities
Operating liabilities OL
Financial obligations FO
Common stockholders’ equity CSE
Total Equities OL + FO + CSE
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Chapter 7Page 216Balance Sheet Reformulated
Operating AssetsOperating assets OAOperating liabilities (OL)
Net operating assets NOA
Financial Obligations & Owners’ EquityFinancial liabilities FOFinancial assets (FA)
Net financial obligations NFOCommon equity CSE
Total NFO & Equity NFO + CSENOA = OA - OLNFA = FA - FOCSE = NOA + NFA (Usually NFA is negative: NFO)CSE = NOA - NFO
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Business Activities:All the Stocks & Flows
• OR is operating revenue
• OE is operating expense
• NFI is net financial income
OR - OE = OI
OR
OE
Chapter 7 Page 218
Figure 7.3
• indicates change
• NFA can be negative (NFO)
Operating Activities Financing Activities
OI - NOA = C - IC - I = NFA - NFI + d
Product and Input Markets
Customers
Suppliers
I
C
The FirmCapital Markets
Debt Holders
or Issuers
Share
Holders
NetFinancial
Assets
(NFA)
NetOperating
Assets
(NOA)
F
d
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Business Activities:All the Stocks & Flows
• OR is operating revenue
• OE is operating expense
• NFI is net financial income
OR - OE = OI
OR
OE
Chapter 7 Page 218
Figure 7.3
• indicates change
• NFA can be negative (NFO)
Operating Activities Financing Activities
OI - NOA = C - IC - I - NFA + NFI = d
Product and Input Markets
Customers
Suppliers
I
C
The FirmCapital Markets
Debt Holders
or Issuers
Share
Holders
NetFinancial
Assets
(NFA)
NetOperating
Assets
(NOA)
F
d
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Business Activities:All the Stocks & Flows
• OR is operating revenue
• OE is operating expense
• NFE is net financial expense
OR - OE = OI
OR
OE
Chapter 7 Page 218
Figure 7.3
• indicates change
• NFA can be negative (NFO)
Operating Activities Financing Activities
OI - NOA = C - IC - I + NFO - NFE = d
Product and Input Markets
Customers
Suppliers
I
C
The FirmCapital Markets
Debt Holders
or Issuers
Share
Holders
NetFinancialObligat’ns
(NFO)
NetOperating
Assets
(NOA)
F
d
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Income Statement
The difference between operating revenue and operating expense is called operating income:
OI = OR - OE
Net financing expense can be negative (net financial income)
Chapter 7 Page 217
Income Statement
Operating income
Operating revenue OR
Operating expense (OE) OI
Net financing expense
Interest expense XX
Interest revenue (XX) (NFE)
Comprehensive incomeEarnings
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Business Activities and theFinancial Statements
Chapter 7 Summary
Net Operating Assets Net Financial Obligations
BALANCESHEET
NOAt = NOAt-1 + OIt - (Ct - It) NFOt = NFOt-1 - (Ct - It) + NFEt + dt
CSEt = CSEt-1 + OIt - NFEt - dt
INCOMESTATEMENT
earnt = OIt - NFEt
CASH FLOWSTATEMENT
Ct - It = dt + Ft
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Stocks & Flows:Operating Activities
• The change in NFO is given by
• The change in NOA is given by
• Operating income in the income statement flows to net operating assets in the balance sheet.
• Free cash flow reduces NOA and reduces NFO (increases NFA). Free cash flow can be seen as a dividend paid from operating to financial activities
ttt1tt ICOINOANOA
tttt1tt dFENICNFONFO
Chapter 7 Pages 220-221
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Tying it Together:What Generates Value?
• From the balance sheet equation
ttt NFONOACSE
Chapter 7 Page 222
• For this to be true, however, accounting must be Clean Surplus.
• Free cash flow drops out in the previous equation: Free cash flow (C - I) does not add value to shareholders.
• What generates value is the profit from operating and financing activities.
• By the way NOA and NFO are calculated,
which is the stocks and flows equation.
ttt
tttt-t
ttttt-ttttt
dearnCSE
dNFEOINFONOA
dNFEICNFOICOINOACSE
1
11
11
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Value Added and Accrual Accounting
OI and NFE are accounting measures and so are determined by accounting principles
NI = (C - I) + i + I + new accruals
OI = (C - I) + I + new operating accruals
= C + new operating accruals
NFE = i + new financing accruals
Chapter 7 Page 223
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Accruals and the Balance Sheet
NOAt = NOAt-1 + It + new operating accrualst
NFOt = NFOt-1 - (Ct - It) + it + new financial accrualst + dt
and
CSEt = CSEt-1 + NOAt - NFOt
Chapter 7 Page 223
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Separating operating and financing activities in the Income Statement identifies profit flows
Comparison of these flows with their asset base yields the corresponding rates of return:
Return on Net Operating Assets
Return on Net Financial Assets
If there are NFO rather than NFA, net borrowing cost
Forecasting ROCE (at the heart of the valuation model) involves both the forecast of RNOA and RNFA (or NBC)
1tt21
tt NOANOAOIRNOA
1tt21
tt NFANFAFINRNFA
1tt21
tt NFONFOFENNBC
Chapter 7Page 224
Stocks & Flows Ratios:Business Profitability